It's the Wrong Conclusion to Assume the Fed Is Actually Ready to Tighten Policy

Economic activity is slowing. This week's drop in Retail Sales was just the latest in a string of sequentially weaker activity numbers. And yet the Federal Reserve has all but decided to taper QE later this year, as evidenced by Wednesday's FOMC meeting minutes. This dichotomy is a major reason why bond yields have been falling in recent weeks as the market has gone from fearing inflation to fearing an overly tight Fed. In my view, people are overreacting to sequential weakness, and in doing so, misunderstanding what is likely to cause inflation to remain elevated. Market says money getting tighter One of Milton Friedman's more famous observations was that tight money led to low interest rates. In that spirit, if we look at various corners of finance we see markets consistently anticipating tight money. To see what I mean, let's look at the period from the Fed's June meeting until now. Remember that the June meeting was when the Fed's dot plot showed the majority of members expecting rate hikes in 2023. The Fed also started talking openly about QE tapering at that same meeting. Here are some major market moves since that time: 10-year Treasury yield: 22bps lower Curve slope (5 vs. 30-year yield): 26bp flatter. US Dollar index: +2.8% Oil: -9.1% Gold: -3.9% Russell 3000 Value vs. Growth: -6.4% All of these are proxies for the tightness of money and/or the state of the business cycle. In all instances, these indicate monetary policy is getting tight, which could suggest the cycle could turn soon. Note that during this time zero additional rate hikes were priced in. The day before the June FOMC meeting, the market had about three hikes priced through 2023. That is exactly the same now. What's different is that now the market thinks those three rate hikes will be a mistake. That these hikes will be enough to not only arrest any nascent inflation, but possibly cut off the recovery entirely. Sequential slowing not meaningful I certainly concede that it is possible that the Fed ultimately tightens too much, but I think bond bulls are making two giant leaps of logic. The first is that the economy is slowing. This might be literally true in the sense that economic activity will probably be slower in 2H 2021 than it was in 1H. But this has very little importance in terms of gaging anything regarding financial markets. Let's take this week's Retail Sales number. From 2016-2019, Retail Sales grew at an annualized 3.8% pace. From the end of 2019 to now, it has grown at an 11.0% rate. Do you think 11% consumption growth is sustainable? Obviously not. So clearly Retail Sales has to slow at some point. It may even fall outright for a period once people have spent down excess savings and/or stimulus checks. This kind of slowing tells us almost nothing about the underlying trend for consumer spending. It certainly doesn't indicate that the economy itself has weak fundamentals. Inflation is about running out of capacity Here's a simple thought exercise to help illustrate why the current slowdown isn't terribly relevant. Let's say that consumer income starts at 100, and for simplicity, that all consumers will spend all income. So income = 100 and spending = 100. Now let's say that the government gives everyone checks equal to 10. Now income = 110 and spending = 110. If the economy can't quickly produce 10% more in goods, there will be some inflation. In fact, let's estimate that the economy can grow unit production at 2%. So there's demand for 110 but only production for 102. This is approximately where we are right now, witness CPI running over 5% in the last year. Now let's say the next year stimulus ends, but consumers have all gotten 5% raises. So their budget falls to from 110 to 105. Producers expand capacity by another 2%, but they are still only at 104. Guess what? We still have inflation! And what if consumers keep getting 5% raises but producers can't accelerate productivity growth? Then inflation will just accelerate all the more. Now is this stagflation? Not really. Not in the sense that anyone is actually worse off. Rather there was a temporary spike in demand that was never going to sustain. Once that passed though, there was enough underlying demand pressure to result in persistent inflation. Let's add one more wrinkle. Say the reason why producers can't make more stuff is because they can't hire enough workers due to tight labor supply. This has two complimentary effects. First, it keeps wage growth high, which in turn helps ensure that consumers have enough budget to fuel goods demand. Second, it prevents supply of goods from expanding to match desired spending. This results in the excess demand turning into inflation instead of more production. Now of course real life is much more complicated than this simple story, but hopefully it illustrates that capacity is key to the inflation picture. Sequential slowing doesn't really matter as long as we are heading toward, or already beyond, capacity. Fed isn't anxious to hike I mentioned above that there were two logical leaps bond bulls were making. The second of these is around QE tapering. Bond bulls think that either tapering QE will have some large effect or they think it is just the first step in a broader tightening cycle, and it is too soon to be tightening. This is vastly overweighting the importance of QE, both in terms of its direct effect and/or in what it tells us about the timing of future rate hikes. To be sure, Wednesday's minutes showed that the Fed is ready to taper. Most participants felt that the economy would likely reach the substantial further progress goal that was set out in December before year-end. However it is the wrong conclusion to assume this means the Fed is actually ready to tighten policy. In a world where banks are constrained by their reserves, QE can loosen money conditions by alleviating that constraint. However right now banks are swimming in reserves. Witness the massive subscription in repo auctions recently. Adding more reserves into the system right now is having no effect on bank activity and therefore no effect on the stance of monetary policy. Hence tapering QE will similarly have no effect. The Fed realizes this is true but can't come right out and say it without creating confusion. They've always claimed QE was part of their monetary toolkit, as it is a convenient way to show they aren't out of bullets once they hit the zero lower bound. They can't now claim that QE has no effect without damaging their ability to use it again the next time they cut to 0%. This has no real read-through for the timing of rate hikes. Again from the July minutes participants indicated that the standards for raising the target range for the federal funds rate were distinct from those associated with tapering asset purchases. My own view is that inflation pressure will turn out to be persistent, just not at the 5% level. If that's true and inflation is running above 2% for the next year or so, the Fed will probably be hiking in late 2022 or early 2023. But if I'm wrong and inflation isn't running that high, then the Fed will just sit pat. Tapering QE now doesn't somehow negate the Average Inflation Targeting approach to policy. One thing doesn't automatically lead to the other. Bond bulls could be right, but... The bull view on bonds isn't totally crazy. It could be that all of the current inflation pressure subsides as supply chain pressures abate. If so, Treasury rates will continue to be this low. However, I don't think that's the most likely outcome. Moreover the risk is definitely skewed. Again, if inflation settles back in below 2%, not much will happen to the yield curve. But if inflation pressure remains high and thus forces the Fed to start tightening, there is substantial room for yields to rise. The prudent thing is to remain defensive on rates.

It's the Wrong Conclusion to Assume the Fed Is Actually Ready to Tighten Policy

The bull view on bonds isn't totally crazy. The prudent thing is to remain defensive on rates.

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